Why fund managers are wary of new ESG categories

To be sure, these funds aim to invest in a basket of securities that score well on the ESG front. Hitherto, asset management companies (AMCs) were permitted to launch only one scheme under the ESG tag.

The six new categories will reflect the different strategies under the ESG theme (see graphic). The first category is ‘exclusion’. Here, fund managers will exclude some securities that are involved in certain undesirable businesses pertaining to coal, tobacco, or alcohol. The second one is ‘integration’, wherein fund managers will consider ESG-related factors alongside traditional financial ones to screen investments. The third category, ‘best-in-class and positive screening’, seeks to invest in companies that perform better than peers on ESG parameters.

The fourth category is ‘impact investing’. Its objective is to generate a positive, measurable social or environmental impact alongside a financial return aspect. The fifth, ‘sustainable objectives’ category, aims to invest in sectors, industries, or companies expected to benefit from long-term macro or structural ESG-related trends. The last, ‘transition’, will invest in companies and issuers that are transitioning towards a more environmentally sustainable business model.

Unanswered Questions

Shamit Chokshi, head, offshore funds investments, who is responsible for the ESG framework at ICICI Prudential AMC, said many ESG fund managers currently incorporate a combination of two or more strategies. In that sense, categorizing existing funds into a single category might be tricky.

“There is a philosophical thought that exclusion, integration, and best in class could be followed in a single fund but in reality, the fund manager may run a combination of strategies,” said Chokshi. “The fund manager may avoid stocks in the tobacco sector and at the same time take into account integration by looking at the financial and valuation aspects of the company,”

There is another concern. Nirav Karkera, head of research at Fisdom, said this categorization will limit the number of stocks the fund managers can choose from. For instance, existing ESG funds can invest in companies following any of the six new strategies. But the smaller categories would result in a smaller pool of stocks to choose from. This would come in the way of an AMC’s primary objective of delivering performance to its investors. The limited universe can also lead to overlap between same-strategy funds.

Experts Mint spoke to said that ESG funds will be exposed to more large caps and restricted from investing in smaller market cap companies. This is because the Sebi circular states that ESG schemes should invest only in companies that have comprehensive Business Responsibility and Sustainability Reporting (BRSR) disclosures. BRSR is a list of disclosures that companies are mandated to make to Sebi regarding ESG norms. But the BRSR scores might not be immediately available for companies with a smaller market capitalization as only a set of larger companies will first start reporting these.

“There could be a risk that portfolios will end up with a large-cap tilt if the BRSR disclosures of smaller companies (including renewable firms) are not timely,” said an industry expert who did not want to be identified.

Earlier, the focus was on the disclosure of strategy by fund managers and allowing investors to choose funds based on that. With various new regulations, Sebi is now becoming more prescriptive on how AMCs can invest in ESG funds. Some experts say that the increasing regulations would result in lower discretion of managers in stock selection and make it more rule-based. In that case, a passive strategy would make more sense for both investors and the AMCs.

“ESG funds are still subject to the fund manager’s discretion but it is no longer that fluid,” said Karkera. “With the parameters tightening and standardized rating processes being implemented, there’s significant scope for ESG-based index funds to be introduced.”

What it means for investors

Vidya Bala, co-founder of Prime Investor, said mutual funds are meant to be simple products and the launch of many categories under the ESG theme would only add to the confusion for individual investors. “The categories themselves are difficult to understand”

Arun Kumar, head of research of Fisdom, said Sebi’s reclassification of mutual fund categories in 2018 was aimed at simplifying investments for the ordinary investor but the ESG categorization mandate seems to be going in the opposite direction. “We have to wait for the AMCs to launch these funds to know what’s happening.”